Protecting Profit

It's Never Tooo Early To Take Steps To Defer Paying Taxes On Home's Sale

January 29, 1995|By Robert Bruss, Tribune Media Services.

Did you sell your residence in 1994? Or, are you planning on selling your home in 1995? If you answered "yes," now is the time to anticipate the best way to avoid paying tax on your home sale profit.

- The rollover residence replacement rule. If you bought or will be buying a replacement principal residence, the "rollover residence replacement rule" of Internal Revenue Code 1034 helps avoid tax on your home sale.

To qualify, the home seller must buy a replacement principal residence costing at least as much as the net (adjusted) sales price of the old home within 24 months before or after the sale. But the mortgage balances of both residences are irrelevant.

The tax deferral from the sale of the old home lasts as long as the qualifying replacement principal residence is owned. An additional benefit is this tax break can be used over and over again to move up to more expensive homes.

However, it cannot be used more frequently than once every 24 months unless the home sale involves a job site change which qualifies for the moving expense deduction.

There is no minimum holding period for the first residence. However, if you sell more than one principal residence within 24 months, profit on the second home sold will be fully taxed even if a third home in the series is purchased (unless you qualify for the moving expense deduction).

- No time extension for the 24-month replacement period. One of the most common problems home sellers encounter is they are unable to complete the purchase and occupancy of their qualifying replacement home within 24 months after the sale of their old home. Unfortunately, there is no provision in IRC 1034 for any time extension, even in hardship cases.

However, if the homeowner is in military service or moves outside the U.S., then up to a four-year delay is allowed for acquiring the replacement residence.

In divorce situations, if each ex-spouse was a co-owner and occupant of the former principal residence sold, each ex-spouse seller need only buy a replacement principal residence costing as much as their share of the net adjusted sales price. One ex-spouse can qualify even if the other ex-spouse does not buy a replacement principal residence.

However, if a joint tax return was filed in the year of the home sale, each ex-spouse is jointly and severally liable for the other spouse's potential tax liability.

For example, in the Murphy case (103 TC 8) the ex-husband who purchased a qualifying replacement home for his half of the old principal residence's sales price was held also liable for profit tax on the other half when his ex-wife failed to buy a replacement home for her half of the sales price. The Tax Court said the joint tax return filed by both spouses in the year of home sale made both ex-spouses jointly liable for the entire home sale tax.

- No need to reinvest cash from home sale. A unique feature of IRC 1034 is cash received from the home sale need not be reinvested into the replacement principal residence. This means, for example, you can sell your old home for cash and defer your entire profit tax even if you buy the replacement home for nothing down, such as with a VA mortgage. You can spend the leftover tax-deferred cash as you wish.

- Expect to pay tax on your profitable sale if you buy a less expensive replacement home. The biggest pitfall of IRC 1034 occurs if you buy a less expensive replacement principal residence. Then your sale profit is taxable up to the difference in the two prices.

To illustrate, suppose your old home sells at a $25,000 profit for a $100,000 adjusted sales price and you buy a replacement principal residence for $90,000. The $10,000 price difference will be taxable but tax on the remaining $15,000 profit is deferred.

However, a little-known method of avoiding tax when buying a less expensive replacement home is to add capital improvements during the 24-month replacement period to bring the new home's cost up to the old home's adjusted sales price. In the example above, spending $10,000 on landscaping or other improvements will avoid profit tax on that amount.

The replacement home must be bought and occupied within 24 months from the old home's sale. Some home sellers incorrectly think they can defer tax by moving to their summer or vacation home which they already own. This is not correct.

The replacement principal residence must be bought and occupied within 24 months before or after the sale of the old principal residence. However, IRC 1034(c)(2) says a currently-owned home can qualify if it is reconstructed or capital improvements are added which cost at least as much as the old home's adjusted sales price.

If a new home is being constructed, it must be bought and occupied by the owners within 24 months of the old principal residence's sale.